This Is Wall Street's No. 1 Lie About Trading Options

The next time you're talking with a group of "informed" investors, bring up the topic of options trading. Before long, someone in your group will cite the supposedly well-known statistic that more than 90% of all options expire worthless.

And most of the other folks will nod in solemn agreement.

Because options have big potential rewards and substantial risks, regulators want us to believe that options are to retail investors what Kryptonite is to Superman.

Because of that, the "90%" stat is presented as trading dogma and is cited over and over and over again - in speeches, in magazines, and in investing analyses of every type.

In fact, I was at a recent conference where a well-known investor quoted the statistic he learned in business school as "98% of all options expire worthless."

There's only one problem.

It's just not true.

In fact, it's one of the biggest investing myths of all time.

I sat down with Money Morning  Executive Editor William Patalon, III, to set the record straight - and unleash your maximum profit potential.

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Here's the Honest Truth About Options Trading

William Patalon, III: D.R... you and I are talking here to, in essence, "bust the myth" about options trading... to blunt the belief that trading options is the stock market equivalent of a "fool's errand."

In fact, just the opposite is true... Isn't that right?

D.R. Barton, Jr.: That's right, Bill. Traded correctly - with the right underlying "mindset" and with the correct trading system - options are certainly the quickest and most powerful way to string together really outsized gains.

WPIII: And with lower risk.

DRB [nodding]: With specifically managed risk - especially relative to potential reward.

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WPIII: Let's go through all of this... because it's a conversation you and I have had many times... and I'm betting folks will find it as fascinating - and as downright surprising - as I did.

DRB: Fire away.

WPIII: And let's start with the obvious.

There's a good reason the idea of trading options terrifies so many investors: The statistics that are often bandied about make it seem like a losing proposition.

DRB: That's exactly how it appears.

But it's a myth... and a myth I can "bust"... fairly easily.

Let's start with the myth itself...

A few years back, the Chicago Mercantile Exchange [CME] did a very detailed study looking at options. It looked at expiring and exercised options over a period of three years - 1997, 1998, and 1999 - and found that an average of 76.5% of all CME options held to expiration expired worthless.

WPIII: Out of the money...

DRB: Yes... out of the money... worthless.

And this was a pretty consistent finding - across all three years - with 76.3%, 75.8%, and 77.5% expiring worthless, respectively.

WPIII: So, from this general level, we can say that for every option exercised "in the money" at expiration, there were three options contracts that expired "out of the money" - hence, worthless.
That means option sellers had better odds than option buyers for positions held until expiration.

DRB: That's right, Bill. Except that there are several problems with the way the results are interpreted.

First, let's talk about the numbers and the fact that the "picture of futility" that the CME data represents is based on holding options to expiration. But we're traders... so, by definition, when we buy options, we never hold them until expiration.

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Second is the fact that many folks treat options as "lottery tickets." People buy options that are really, really far from the current price - which, in the language of trading, is referred to as "deeply out-of-the-money options." They do this because the options are cheap in price. And because they're "moonshots" - meaning that, if they hit, they hit big. That's their allure. But it's also their weak point. Like most long shots, these don't pay off: Practically all of these lottery-ticket style options expire out of the money. And worthless.

WPIII: And that drives up the overall percentage of options that expire worthless as reported by the study.

DRB: Exactly. So instead of looking at what would happen if you held on to options in the least advantageous way, as the study suggests, we focus on probabilities for profit opportunities on shorter-term plays. And, of course, on managing risk.

WPIII: Let's start with the "opportunity" concept.

DRB: Sure. There are opportunities to use the leverage of options to make very large profits in a short amount of time.

WPIII: And what's really striking is that you're able to do this - even if the market or the stock you're trading is making very small moves.

DRB: Yes. That's because - if we use the natural monetary leverage of options - we can find trading opportunities with high probabilities for quick moves and make big returns... with only a modest move in the stock or index we're trading.

WPIII: And when you say "big returns," you're even talking about the potential for triple-digit returns.

DRB: That's right.

WPIII: OK... and I can almost hear some folks out there saying, "That's great, D.R., but how can I build large amounts of wealth if so many options expire worthless?"

DRB: I'm glad you asked that.
Remember how - just a moment ago - I said that those daunting, high percentages for options expiring worthless was just an "average?" Well, here's where that comes into effect.

WPIII: As well as the concept of "probability."

DRB [nodding and smiling]: And the concept of probability.

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Those terrible CME numbers were averages of options trades across ALL sectors, across ALL time frames, across ALL markets, and across ALL situations [backdrops].

As a trader, I don't operate in that manner.

In my book, The 10-Minute Millionaire, I explain how my trading strategy is designed to identify stocks (and therefore, the associated options) that are trading at an "extreme."
Said another way - I only have us buy options when the market probabilities are in our favor - when we have an edge.

That's why I developed my 10-Minute Millionaire system, to take the guesswork out of something that's otherwise very tricky. The system serves as a kind of "radar" that lets me zero right in on stocks that are trading at "extreme" highs or "extreme" lows.

This means the stocks in question have been driven by investors up to their euphoric apex [highs] or beaten down to their doleful nadirs [lows].

WPIII: And that's very, very important... and, in fact, is where increased probability comes into the picture.

DRB: Yes!

You see, when a stock has been driven to an extreme, the odds are very good that its next move will be in the opposite direction. I don't necessarily mean the next move a second later... nothing that granular. I'm talking about the next trend... be it an intermediate-duration move or even a longer-term one.

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Take a stock that's been driven to a euphoric high...

The fact that it's at an "extreme," by definition, means it's not going to continue in that same direction. It's going to reverse course and go down.

Conversely, a stock that's been beaten to an "extreme low" is poised for a reversal to the upside.

In both instances, the probability is high that the stock will change direction. And if you understand that, you can make money. You can make money with the stock itself. Or you can "leverage" that opportunity and make an even bigger return by trading the option.

WPIII: And to profit, you want to sell (go short on) stocks that are trading at extreme highs since they are poised to reverse course and fall. And you want to buy (go long on) stocks that have achieved an extreme low since they are poised to reverse course and climb.

DRB: In a nutshell, Bill, that's really it. Trading the stocks can be very profitable. But using options allows you to leverage those opportunities and make even more money because you're risking small amounts of capital for very big gains.

WPIII: That's the essence of your system... using mathematical probabilities to ID stocks trading at extreme highs or extreme lows - even if those extremes are intermediate ones - and using options to grab "leveraged" windfalls when they reverse course. And that's why the options trades that you do aren't going to track the horrendous overall options record depicted in the CME study.

DRB: That's it... In fact, my experience and that of my subscribers shows it's the exact opposite of what those numbers seem to say about the futility of options trading...

WPIII: So myth busted.

DRB: Busted - no matter what Wall Street or the CME would have you believe.

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About the Author

D.R. Barton, Jr., Technical Trading Specialist for Money Map Press, is a world-renowned authority on technical trading with 25 years of experience. He spent the first part of his career as a chemical engineer with DuPont. During this time, he researched and developed the trading secrets that led to his first successful research service. Thanks to the wealth he was able to create for himself and his followers, D.R. retired early to pursue his passion for investing and showing fellow investors how to build toward financial freedom.

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